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Saturday, 27 March 2010

Whenever there’s some kind of major market crash and people start looking for handy scapegoats the usual line-up of suspects will include a preponderance of short-sellers, accused of unpatriotically selling stocks they don’t own in order to make windfall profits. It’s as though making a profit when everyone else is losing money suddenly becomes wrong. When times are tough it seems everyone’s a bleeding heart socialist.

Instead of banning short-selling regulators ought to be focusing on what measures they could take to make it more popular. If you want markets to be roughly efficient and not to fly off on some behaviourally induced flight of fancy then you need intelligent investors to be able to short-sell over-valued stocks. Waiting until everything goes wrong and then artificially distorting the markets in order to apply a tiny band-aid to a market holed below the waterline by a bloody great iceberg of behavioural bias is to invert cause and effect. Short-selling doesn’t cause market crashes, people do.

Shorting’s Scary

Shorting a stock is roughly the opposite to buying it. Technically you’re selling a security you don’t own and then waiting for it to fall so you can buy it back at a lower price, pocketing the difference. Although there are different ways of shorting there are ultimately only a couple of basic variations – covered shorting where you either own or, more likely, borrow the stock for a fee or naked shorting where you actually don’t have any of the stock you’re selling.

Shorting shares is not, generally, a widespread activity amongst investors. There are multiple reasons for this. Many institutional investors aren’t allowed to short stocks due to their remit, most individual investors don’t short due to behavioural issues and fears of unlimited losses. These individual concerns are linked – as we saw in discussing behavioural portfolios investors don’t like their losses from their upside potential layer eating into their downside protection layer, but as losses from shorting are potentially unlimited, this is a real risk for short-side investors.

Unlimited Liability

When we buy stocks the maximum we risk is the capital we put down up front, but when we short a stock our losses are potentially infinite: the higher a stock goes, the greater the loss. Perhaps not unreasonably investors are wary of risking their capital in this way. However, not shorting is also problematic even under efficient market hypotheses because obtaining a portfolio that meets the blessed combination of maximum return for minimum risk almost certainly requires investors to go short some of the time. Yet by and large people don’t because of the nasty downside of the approach.

In fact there was a time when buying stocks was pretty much as risky as shorting stocks is today, if not more so. Today when we buy a stock we risk only our starting capital but a couple of hundred years ago the situation was very different. The concept of limited liability was virtually unknown – shareholders were responsible for the debts of their companies and if the company was unable to pay what it owed then shareholders could expect to be tapped up for additional funds.

Aligning Lenders With Shareholders

Now you might think that unlimited liability would properly align shareholders interests with that of management. Only you’d be wrong, because with all liability ultimately residing with the shareholders lenders were happy to throw money at managers who promptly wasted it in the normal ways that managers do, making reckless overpriced overseas acquisitions, spending vast amounts of money on corporate galleons and generally taking ye olde risks with other people’s money.

Enacting limited liability reversed the direction of risk and made the lenders, not the shareholders, responsible for the risk of any transaction. Hard though it is to believe, corporations are less risky now than they used to be. Limited liability is the result of pure behavioural psychology in operation. As Daniel Moss puts it in When All Else Fails:

“When it comes to losses, therefore, magnitudes generally carry disproportionately more weight than probabilities, particularly in the extreme. And this is why limited liability is likely to deliver a net benefit – because shareholders may well gain more satisfaction from the sharp reduction in their maximum possible loss (their “risk of utter ruin”) than creditors lose from the corresponding increase in their probability of a more limited loss.”

This, of course, is exactly the situation that short-sellers find themselves in today, facing the possibility of unlimited liability and even utter ruin if their gambles go against them. Unsurprisingly most investors would rather ride out the downward waves of market movements than try to bet on them.

Efficiency Through Short Selling

Unfortunately this matters, and rather a lot, when it comes to the management of behaviourally induced bubbles in markets and stocks. As we’ve seen before the general theory of efficient markets is that bubbles can’t exist because if dumb money pushes stocks to silly prices then smart money will pull them back again. However, if the smart money is unwilling to go short of stocks or markets because of the unlimited liability and related behavioural drivers associated with short-selling then it’s pretty easy to see how runaway forward feedback can cause the silly money to accumulate into a humongously overpriced market.

“In a market with little or no short selling the demand for a particular security will come from the minority who hold the most optimistic expectations about it. ... The presence of a substantial number of well informed investors will prevent there from being substantially undervalued securities, but there may be securities whose price have been bid up to excessive levels by a badly informed minority, thus contradicting the efficient market hypothesis.”

When The Mad Take Flight

So essentially Miller argues for a stock to become overvalued there needs to be a constraint on short-sellers and there needs to be a disagreement amongst investors about the fundamental valuation of the company. The latter means that only optimists own the share while the former means that pessimists can only register their disagreement by owning no shares rather than owning negative quantities. Because no shares means no downward pressure the stock price gets pushed upwards by a small number of over-optimistic investors trading amongst themselves.

Boeheme, Danielsen and Sorescu investigated this idea and basically concluded that Miller was correct. Both conditions need to be satisfied for stocks to fly off into an overvalued void – in the absence of the ability to effectively short a stock the behavioural fancies of a few can cause bubbles in individual stocks and, in the extreme, markets.

How Not To Manage A Market

The researchers suggest that their findings indicate that if regulators wish to reduce the boom and bust cycle of markets they should look to find ways of reducing the costs of short selling while improving the transparency of information around stock lending markets. Sadly the reaction of the authorities to the inevitable busts that follow booms is usually exactly the opposite.

James Meeker, in his classic book on the subject Short Selling, recorded that government autocrats the world over, from Napoleon Bonaparte to Edgar J. Hoover, have attempted to restrict short selling. Invariably this happens after stock market crashes in a feeble attempt to keep prices high; similar rules were enacted in the wake of the collapses in 2008. Our regulators and politicians would do better to try and figure out how to stop markets becoming overpriced in the first place. Making it less risky and less expensive to short stocks would be a good start.

3 comments:

Our regulators and politicians would do better to try and figure out how to stop markets becoming overpriced in the first place.

Yes. Once a market becomes overvalued, it's hard to get prices back to normal because all investors see themselves as obtaining a benefit from the overvaluation. Overvaluation begets greater overvaluation. Overvaluation is something that needs to be stopped in the early stages if it is to be stopped at all (and to fail to stop it is to insure an economic crisis).

Making it less risky and less expensive to short stocks would be a good start.

I think the more effective way to stop overvaluation is to encourage all investors to adjust their allocations in response to big price changes. That makes it impossible for overvaluation to gain a foothold.

Another possibility would be to permit long-term shorting of the market. If those who understand valuations could take a bet that stocks will be crashing within 10 years, overvaluation would never again take place because the rewards of betting on a crash would be so great that these bets (which would pull prices down) would become all the rage.

Today, there is no way to benefit from knowing that a crash is coming within 10 years. That's the primary reason why the market is so wildly inefficient today. We need to provide financial incentives for betting against overvaluation for market inputs to become balanced.

"The researchers suggest that their findings indicate that if regulators wish to reduce the boom and bust cycle of markets they should look to find ways of reducing the costs of short selling while improving the transparency of information around stock lending markets. Sadly the reaction of the authorities to the inevitable busts that follow booms is usually exactly the opposite."

Worth noting Yves Smith recent post challenging some of this logic, in connection with Michael Lewis' lionization of various short-sellers in the Big Short. She persuasively argues that certain shorting behavior had the perverse behavior of extending the boom:

"The subprime market would have died a much earlier, much less costly death absent the actions of the men Lewis celebrates. They didn’t simply keep the market going well past its sell-by date, they were the moving force behind otherwise inexplicable, superheated demand for the very worst sort of mortgages. His “heroes” were aggressively trying to find toxic waste to wager against. But unlike short positions in heavily-regulated equity markets, these wagers, the credit default swaps, had real economy effects. The use of CDOs masked the nature of their wagers and brought unwitting BBB protection sellers to the table, which lowered CDS spreads (and as in corporate bond markets, CDS dictate, via arbitrage, interest rates for bond issues) and pushed down the interest rates on the cash bonds backed by those same loans, which in turn made it perversely attractive for lenders to generate mortgages with the worst characteristics."

More here: http://www.nakedcapitalism.com/2010/03/debunking-michael-lewis-subprime-short-hagiography.html

I don't disagree with that: the evidence seems clearcut that behaviour of this type did cause real-world economic issues. However, the problem here wasn't shorting but regulation, or the lack of. In the arms race between speculators and regulators the former are usually the winners. In a world in which profit is the only motive then what else can we expect?